Article excerpt

Here is a theory that once enjoyed the status of economic holy
writ: When an economy goes sour, businesses cut prices and workers
accept lower wages. As costs and prices fall, demand rises to meet
supply and the sluggish economy automatically perks up at a new
"equilibrium."

In other words, depressed economies contain a built-in
self-cure.

Students of economics will recognize here the dim outlines of
the "classical" market theory that prevailed well into the Great
Depression, when real-world conditions belied it spectacularly. And
indeed, it was not until John Maynard Keynes published his "General
Theory of Employment, Interest and Money" in 1936 that economists
began to see why depressions were not necessarily self-correcting.

Keynes' recommendations were so shocking to the old order that
their merit was very slowly conceded. Governments, he said, should
if necessary borrow to stimulate demand; and it would be better to
hire people to dig holes or build pyramids (policies still
dismissed by smart-aleck ignoramuses as "leaf-raking") than to wait
for grotesque levels of unemployment to correct themselves.

What is my point? A tutorial in Economic Theory 101? No, a
random thought or two inspired by the news that Robert Lucas Jr. of
the University of Chicago has won the Nobel Memorial Prize in
Economic Science. My learned friends tell me that it is richly
deserved.

About a quarter-century ago, Lucas devised "rational
expectations" theory, which says in essence that major actors in
the economy become so canny through experience that they know all
the government's moves and anticipate and discount their results -
ultimately nullifying their intended effect.

No doubt there is truth here, as there is in Lucas' skepticism
of the wisdom of his own guild. "As an advice-giving profession,"
he once declared, "we are way over our heads."

It is now said that Lucas and his disciples have dealt a death
blow to the "myth" of "fine-tuning," the idea that government
fiscal and monetary policies can chart the course of a
sophisticated mixed economy like that of the United States and the
other major industrial powers.

Let us concede, as many economists now seem to do, that
"rational expectations" will trump "fine-tuning" in most instances. …